Cost of Capital vs ROI: Does Borrowing Pay Off?

Two numbers, one decision

Compare the profit a project will add against the total dollars the funding will cost. If profit is not comfortably larger, the project fails the test.

Owners often ask whether a rate is good. A better question is whether the project is good enough to carry the rate. A 25 percent cost is a bargain on a project that returns 80 percent and ruinous on one that returns 10.

Notice that both numbers must be in the same units. Use dollars of profit added and dollars of financing cost, over the same period. Revenue is not return. Only profit that the money creates counts, after the direct costs of earning it.

How to estimate ROI on borrowed money

ROI equals added profit minus financing cost, divided by the amount invested. Use conservative inputs and ignore revenue you would have earned anyway.

Work through it in four steps.

1. Define the change. What exactly will the money buy: a machine, inventory, a hire, an ad campaign?
2. Estimate added gross profit, not revenue, and only the part that would not happen without the money.
3. Subtract the financing cost in dollars. See true cost of capital.
4. Divide by the amount invested.

These figures are examples only. Replace them with your own, and cut the job count by a third to see if it still works.

Add the time dimension: payback period

Payback period is how many months until the project has earned back its cost. Shorter paybacks reduce risk and match short-term funding better.

A strong total return that arrives in three years is a poor match for financing repaid in nine months. Compare when cash comes in with when cash goes out.

Divide the total funding cost plus principal by the monthly net cash the project produces. If a project returns $3,000 a month and you owe a combined $30,000 in repayments, payback is ten months. If the term is twelve months, you are covered with only two months to spare. Our guide to payback period goes deeper, and the equipment payback calculator applies it to machinery.

Projects that usually clear the bar

Projects with a direct, measurable link between money in and profit out tend to pay: inventory that turns, equipment that adds capacity, and proven marketing.

Some uses of funds have an easy line to profit.

• Inventory with a known sell-through, where you can see how quickly and at what margin it sells. See inventory funding payback math.
• Equipment that removes a capacity limit, when you are turning away work.
• Marketing with a tested channel, where a dollar spent has a known return. See marketing payback math.
• Consolidating higher-cost debt into a lower total cost.

In each case, you can write the return as a number before you sign.

Uses that rarely pay back

Covering recurring losses, funding vague growth ideas, or paying one-off costs with expensive short-term money usually fails the ROI test.

Be honest about a few patterns.

• Funding a loss. If the business loses money every month, new financing postpones the problem and adds cost.
• Hope-based spending. A new location with no demand evidence is a bet, not a project with a return.
• Long-lived assets on short money. A ten-year asset financed over six months strains cash flow even if the asset is good.
• Paying for one-time costs at a high effective rate when cheaper options such as a line of credit exist.

Sometimes the useful answer is to wait, cut a cost or negotiate with a supplier. A good funding partner should say so.

A quick checklist before you apply

Five questions will tell you whether the project is ready for financing.

Can you name the specific purchase or project? Can you state the added monthly profit in dollars, with a reason for the estimate? Do you know the total repayment and the month you break even? Does the plan still work if results come in 30 percent lower? Is there a cheaper way to reach the same goal, such as leasing or phasing the project?

If you can answer yes to all five, you are applying from a position of strength. If two or more are no, spend a week on the numbers first. The time costs nothing, and funding is better used on a plan than on an idea.

Putting the test into practice

Write down the added profit, the full cost, the payback month and a downside case. If the downside still covers payments, move forward.

A one-page summary is enough. Include the use of funds, the expected monthly gain, the total cost, the month you break even and what happens if results come in 30 percent lower. Our stress test guide helps with the last piece.

ROI Funder builds its process around this. You see the true cost, payback period and monthly-equivalent payment before you sign. Funding ranges from $5,000 to $5,000,000, and applying takes a few minutes with a soft credit pull. If the numbers do not work, you owe nothing and have lost nothing. Start at the application.